Qualified Plans and Estate Planning
November 1, 2017
Between 1980 and 2008, the number of employees covered by a defined benefit pension plan has decreased from 38 percent to 20 percent.[1] This decline has led to more employees contributing assets to qualified plans such as IRAs and 401(k)s, and these plans can make up a substantial portion of the client’s estate. When advising a client with regard to their estate plan, it is important to give special consideration to these plans and the beneficiary designation associated with them. The beneficiary designation determines how long distributions from the qualified plan can be spread out, thereby delaying payment of income taxes. The main beneficiary designations of qualified plans are individuals, a spouse, Trusts, Estates, and charities.
Individuals
If your client names an individual as the sole beneficiary of the qualified plan, that individual can elect to take their inheritance as an Inherited IRA. They are required to take Required Minimum Distributions (RMDs) each year based on their life expectancy, beginning in the year after the original owner’s death. The benefit is that the individual only has to pay income tax on the RMD amount each year; if the person took the IRA in one lump sum, they would be taxed on the full value of the qualified plan in one year rather than being able to spread out the income tax over multiple years.
If your client name more than one individual as beneficiary of the qualified plan, each individual can use their own life expectancy to determine their annual RMD, so long as the IRA is split into separate inherited IRAs by December 31st of the year after the death of the original IRA owner. If the IRA is not split in time, the RMD for all beneficiaries is based on the oldest beneficiary’s life expectancy.
Spouse
If your client names their spouse as the sole beneficiary of the qualified plan, the spouse can elect to take their inheritance and roll it over into their own IRA. The same rules for taking RMDs would apply to the rollover IRA as would apply to a normal IRA. This can be very beneficial from a tax standpoint if the spouse is under 70 ½ since the spouse would not have to take a withdrawal from the IRA until he/she turns 70 ½.
Trust
If your client names a Trust as the sole beneficiary of the qualified plan, the RMD calculation determination is much more complex. In general, RMDs for each beneficiary of the Trust are based on the life expectancy of the oldest beneficiary. However, if the Trust is not a Qualified Trust[2](for example, if a beneficiary of the Trust is a charity), the Trust may have to take RMDs based on the deceased owner’s life expectancy, or withdraw the entire balance within 5 years of the original owner’s death (if the original owner died before reaching 70 ½).
Estate
If your client names their estate as beneficiary of the qualified plan (or you do not have a beneficiary designation and your qualified plan defaults to your estate), there are two possibilities. If the owner died before age 70 ½, the beneficiary must take the full balance of the qualified plan within 5 years of the owner’s death. If the owner died after age 70 ½, the RMDs will be based on the owner’s remaining life expectancy.
Charities
If your client names a charity as the beneficiary of the qualified plan, the charity does not need the benefit of electing to take the qualified plan as an Inherited IRA. The charity will not pay tax on the funds, and therefore can simply take a lump sum distribution of the qualified plan assets. If a client has any charitable inclinations, it is wise to name the charities as the direct beneficiary of your qualified plan since the charities will not be required to pay tax on the distribution.
Conclusion
Naming beneficiaries for qualified plans is very complex. Serious consideration should be given to the beneficiary designation since different rules apply depending on who (or what) is named as beneficiary. Regardless of the choice, you should make sure that the financial institution confirms in writing that they have made the requested beneficiary designation. This is meant only as a brief overview of the rules; there are other considerations and exceptions, especially when naming a Trust as beneficiary of a qualified plan.
If you have any questions, please feel free to reach out to Nathan Beemster at
[1] “The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers” by Barbara A. Butrica, Howard M. Iams, Karen E. Smith, and Eric J. Toder, Social Security Bulletin, Vol. 69, No. 3, 2009.
[2] To be qualified, a trust must be valid under state law, must be irrevocable (or become irrevocable when the retirement account holder dies) and must have identifiable beneficiaries. Furthermore, the IRA trustee, custodian or plan administrator must be provided with a copy of the trust agreement by October 31 of the year following the original owner’s death.